New Pension Math

In most states, the benefits formulas for active employees are untouchable. The only way to chip away at pension-funding problems is to fiddle with formulas for new employees, partly because unions are more willing to give way on benefits for new hires. Newbies don't vote on today's contract and don't pay dues yet--and union leaders may figure they'll get the benefits restored when the economy improves.

For most public officials, there is great confusion about what would be a fair benefits formula for new employees. Here are some pension math basics:

Cost-sharing. Let's assume the pension fund requires employees to contribute 5 percent of their salary, the national average, to the pension plan. A good case can be made that new employees should pay half of their pension benefits' normal costs, which helps assure they have skin in the game when it comes time to talk about future benefits increases. One of the first issues to address is the employee contribution rate. If the rate is less than half of what the actuary says would be the normal cost of new hires' benefits, it's time to put that issue on the table.

Retirement age. Public employees in many states receive lifetime pensions and sometimes medical benefits long before Social Security's normal retirement age-and usually much earlier than their private-sector counterparts who pay the taxes. Putting aside the special cases of police officers and firefighters whose exposure to danger would justify an earlier retirement age, there's little reason for new hires to begin full pension benefits before reaching the Social Security retirement age (now 66 or 67 for baby boomers). Benefits formulas for new employees should start there and allow an earlier retirement with actuarially reduced benefits--just like Social Security requires of early retirees.

Multiplier math. During the Internet bubble years of 1999-2000, many public plans awarded generous increases in the "multiplier"--the percentage used to calculate pension benefits. (For example, a 2 percent multiplier times 30 years of service times a $50,000 final average salary equals a $30,000 annual pension.) Today many pension plans and employers are finding that their multipliers are unsustainable and often unjustified.

If employees are eligible for Social Security, as most are, a multiplier of 1.7 percent would provide a 30-year employee with a pension of one-half of his or her final salary. When that is combined with Social Security and income from personal savings, average retirees will be able to replace their earnings because they no longer will be making pension and Social Security contributions or putting money into a savings account. And hopefully they pay off the mortgage early in the retirement years, thereby reducing living costs. The usual rule of thumb is 85 percent replacement income will sustain a retiree, as long as the retiree has some inflation protection from the pension plan and Social Security.

For public employers outside of Social Security, a multiplier of 2.5 percent is a reasonable benefit level as long as employees pay at least 10 percent of salary into the plan. After all, they're not paying Social Security taxes of 6.2 percent, which makes 10 percent a bargain for them. Many such public employees still find a way to qualify for some Social Security benefits through side jobs and prior or post careers.

As for public safety employees, a multiplier of 2.3 percent plus Social Security and personal savings will generally provide a sufficient replacement ratio--again depending on how early the employee becomes eligible for retirement. At this level, the employee's matching share of normal costs will likely be in the high single digits, if not greater.

Retiree medical benefits. An equally important issue to address with new hires is their retiree medical package. Some employers are now limiting that benefit to post-Medicare supplements only and putting a consumer price index or dollar cap on the benefit to prevent future runaway medical costs. Limiting retiree medical benefits this way reinforces the higher retirement ages needed to sustain pension plans past 2030.

With these reforms, most plans can provide a sufficient benefit. Only a financial analysis can determine if the benefit package would be sustainable and affordable to both the employer and the new hires.